For about ten years after publication of Fama's classic exposition in 1970, the Efficient Markets Hypothesis dominated the academic and business scene. A steady stream of studies and articles, both theoretical and empirical in approach, almost unanimously tended to back up the findings of EMH. As Jensen (1978) wrote: ‘There is no other proposition in economics which has more solid empirical evidence supporting it than the EMH.’
If a market is strong-form efficient, the current market price is the best available unbiased predictor of a fair price, having regard to all relevant information, whether the information is in the public domain or not. As we have seen, this implies that excess returns cannot consistently be achieved even by trading on inside information. This does prompt the interesting observation that must be the first to trade on the inside information and hence make an excess return. Attractive as this line of reasoning may be in theory, it is unfortunately well-nigh impossible to test it in practice with any degree of academic rigour.
(b) The fact that the deviations from true value are random implies, in a rough sense, that there is an equal chance that stocks are under or over valued at any point in time, and that these deviations are uncorrelated with any observable variable. For instance, in an efficient market, stocks with lower PE ratios should be no more or less likely to under valued than stocks with high PE ratios.
(a) Market efficiency does not require that the market price be equal to true value at every point in time. All it requires is that errors in the market price be unbiased, i.e., that prices can be greater than or less than true value, as long as these deviations are random.
(a) In an efficient market, equity research and valuation would be a costly task that provided no benefits. The odds of finding an undervalued stock should be random (50/50). At best, the benefits from information collection and equity research would cover the costs of doing the research.
We always get, as I assume you have asked your adviser, the question, “What do you think the market is going to do this year?” If your adviser answers this question, you are probably already in trouble because your adviser doesn’t know. No one knows! Mr. Market does not share his long-term health condition with us, he only tells us how he is feeling at the moment. Whatever that is, it will change constantly over relatively short periods. He may not feel well now, but in a few weeks he will be up and moving again, or vice versa. One must listen closely every day, every month, and he will tell us if we know what we should be listening for.
If a market is weak-form efficient, there is no correlation between successive prices, so that excess returns cannot consistently be achieved through the study of past price movements. This kind of study is called or analysis, because it is based on the study of past price patterns without regard to any further background information.
In a slightly less rigorous form, the EMH says a market is efficient if all relevant information is quickly reflected in the market price. This is called the form of the EMH. If the strong form is theoretically the most compelling, then the semi-strong form perhaps appeals most to our common sense. It says that the market will quickly digest the publication of relevant new information by moving the price to a new equilibrium level that reflects the change in supply and demand caused by the emergence of that information. What it may lack in intellectual rigour, the semi-strong form of EMH certainly gains in empirical strength, as it is less difficult to test than the strong form.
In its strongest form, the EMH says a market is efficient if all information relevant to the value of a share, whether or not generally available to existing or potential investors, is quickly and accurately reflected in the market price. For example, if the current market price is lower than the value justified by some piece of held information, the holders of that information will exploit the pricing anomaly by buying the shares. They will continue doing so until this excess demand for the shares has driven the price up to the level supported by their private information. At this point they will have no incentive to continue buying, so they will withdraw from the market and the price will stabilise at this new equilibrium level. This is called the of the EMH. It is the most satisfying and compelling form of EMH in a theoretical sense, but it suffers from one big drawback in practice. It is difficult to confirm empirically, as the necessary research would be unlikely to win the cooperation of the relevant section of the financial community – insider dealers.
If a market is semi-strong efficient, the current market price is the best available unbiased predictor of a fair price, having regard to all publicly available information about the risk and return of an investment. The study of public information (and not just past prices) cannot yield consistent excess returns. This is a somewhat more controversial conclusion than that of the weak-form EMH, because it means that analysis – the systematic study of companies, sectors and the economy at large – cannot produce consistently higher returns than are justified by the risks involved. Such a finding calls into question the relevance and value of a large sector of the financial services industry, namely investment research and analysis.
An ‘efficient’ market is defined as a market where there are large numbers of rational, profit ‘maximisers’ actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.
Our experience, market understanding and extensive contacts drive the Target Hypothesis process which generates deal flow and offers clients the most efficient path to sourcing a transaction. Client time is better used running the company than creating an M&A process